Advanced Financial Accounting, 6e

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Advanced Financial Accounting, 6e (Beechy/Trivedi/MacAulay)

Chapter 1 Setting the Stage

1) Which of the following Canadian accounting standards are not included in the CICA Handbook?

A) Publicly accountable enterprises

B) Private enterprises

C) Not for profit organizations

D) Government

Answer: D

Type: MC Page Ref: 4

Difficulty: Easy

2) Which of the following financial reporting objectives is a user objective?

A) Income tax deferral

B) Net income maximization

C) Cash flow prediction

D) Income smoothing

Answer: C


Difficulty: Easy

3) Which financial reporting objective is common to both users and preparers of financial statements?

A) Cash flow prediction

B) Contract compliance

C) Income tax deferral

D) Net income maximization

Answer: B

Type: MC Page Ref: 5 7

Difficulty: Moderate

4) Which of the following financial statements would likely be the most effective in conveying information to users that will help them to predict the long term future cash flows of the company?

A) A classified balance sheet prepared under the accrual basis of accounting

B) A proforma cash flow statement showing expected cash flows for the next year

C) A multi step income statement prepared under the accrual basis of accounting

D) A cash flow statement showing actual cash flows for the past two year

Answer: C





5) A company has chosen accounting policies that result in maximizing its net income. Which of the following is not a reason for doing this?

A) To comply with loan agreement maintenance tests

B) For favourable performance evaluation

C) For cash flow prediction

D) To attract new investors

Answer: C



6) How do financial analysts refer to earnings that correspond closely to cash flows?

A) Cash flow per share

B) High quality earnings

C) Earnings determined on a cash basis

D) Low quality earnings

Answer: B


Difficulty: Easy

7) Which of the following covenants would not appear in a loan agreement?

A) Limits on additional debt

B) Dividend payout limitations

C) Valuation

D) Minimum times interest earned ratio

Answer: C



8) In preparing financial statements with cash flow prediction as a major objective, a company should choose an accounting policy that ________.

A) allows a cost to be capitalized

B) allows a cost to be expensed

C) results in income smoothing

D) maximizes net income

Answer: B



9) Which of the following is not one of the major reporting objectives of financial statement preparers?

A) Prediction of future cash flows

B) Compliance monitoring

C) Fraud detection

D) Performance evaluation

Answer: C





10) A company has chosen accounting policies that result in minimizing its net income. Which of the following is not a reason for doing this?

A) Income tax deferral

B) Performance evaluation

C) Discourage new competitors

D) For negotiations with unions

Answer: B



11) What is often the main motivation behind the practice of taking a "big bath" in a loss year?

A) To minimize income taxes

B) To smooth income

C) To maximize asset book values

D) To increase future years' earnings

Answer: D


Difficulty: Easy

12) How does a company usually take a "big bath" in a loss year?

A) Reduces its long term liabilities

B) Expenses as many of its costs as possible

C) Recognizes revenue as soon as possible

D) Writes down its assets

Answer: D



13) What effect does income smoothing have on risk analysis?

A) Reduces the business risk of a company

B) Increases the financial risk of a company

C) Reduces the audit risk of a company

D) Has no effect on risk analysis

Answer: A



14) Which of the following statements about income smoothing is true?

A) Incoming smoothing can only be accomplished through revenue recognition policies.

B) Income smoothing can only be accomplished through the use of estimates.

C) IFRS provides more opportunities for income smoothing than under pre IFRS GAAP.

D) Income smoothing through expense recognition policies is effective if there is a strong relationship between expenses and revenues.

Answer: D





15) Choco Chocolate is the wholly owned Canadian subsidiary of the Yummy Candy Company, a publicly traded US company. Which accounting standards must Choco Chocolate comply with?

A) IFRS

B) Canadian Accounting Standards for Private Enterprises

C) US GAAP

D) Whatever standards are prescribed by any loan agreements that Choco has with its lending institutions

Answer: C



16) Which of the following user groups has the most influence on reporting objectives?

A) Canada Revenue Agency

B) The company's audit committee

C) The company's major lenders

D) Industry security analysts

Answer: B


Difficulty: Easy

17) What does accounting harmonization refer to?

A) The smoothing of income between periods by a company

B) Achieving a high level of consistency among accounting standards of different countries

C) All companies using the same accounting standards

D) Reconciling financial statements prepared under pre IFRS GAAP to financial statements prepared under IFRS

Answer: B



18) In the U.S., accounting standards are set by the Financial Accounting Standards Board (FASB). From which body does FASB derive its authority?

A) US government

B) American Institute of Certified Public Accountants (AICPA)

C) Securities and Exchange Commission (SEC)

D) International Accounting Standards Board (IASB)

Answer: C





19) Which of the following statements on professional judgment is not true?

A) The exercise of professional judgment requires the availability of benchmarks or explicit criteria by which to evaluate alternatives.

B) The use of professional judgment represents arbitrary behaviour.

C) An auditor must use his or her professional judgment to determine whether management's choices are suitable within the context of the company.

D) Applying the mandatory disclosure requirements of the CICA Handbook often involves professional judgment.

Answer: B



20) Professional judgement is based on criteria that include certain characteristics of accounting. Which of the following is not one of these characteristics?

A) Timeliness

B) Relevance

C) Efficiency

D) Verifiability

Answer: C



21) Which of the following statements about IFRS is true?

A) IFRS is more rule based than pre IFRS GAAP.

B) IFRS reduces the number of management estimates that can be used.

C) IFRS requires more judgement in selecting appropriate accounting policies than under pre IFRS

GAAP.

D) IFRS does not require as strong an accounting infrastructure as under pre IFRS GAAP.

Answer: C



22) When the International Accounting Standards Board amends a standard, what must a code law country do to adopt the amendment?

A) The country's securities regulators must approve the amendment.

B) The country's professional accounting body must approve the amendment.

C) The country must pass new legislation to adopt the amendment.

D) The country's financial institution regulators must approve the amendment.

Answer: C





23) For international standards to be applied effectively, a country does not require ________.

A) professional financial preparers

B) quality auditors

C) an independent enforcement agency

D) companies with ethical managers

Answer: C



24) What is one of the main reasons why securities commissions are often ineffective enforcement agencies for accounting standards?

A) Lack of knowledge

B) Lack of financing

C) Lack of independence

D) Lack of support from professional accounting bodies

Answer: B



25) What was the main reason for adopting international standards?

A) Internationalization of securities markets

B) Internationalization of financial markets

C) Globalization of business

D) Increasing complexity of GAAP

Answer: A



26) Both Canada and Japan have adopted IFRS even though the two countries differ in many ways. What is one areas in which the two countries differ?

A) Corporate structure

B) Issuance of consolidated financial statements

C) Use of common law

D) Ability to select accounting policies

Answer: A


Difficulty: Difficult

27) Which financial reporting approach has Canada decided to take with respect to private enterprises?

A) IFRS

B) Special adaptation of IFRS for small and medium enterprises

C) Canadian GAAP for private enterprises

D) Disclosed basis of accounting

Answer: C


Difficulty: Easy



28) Sheng Ltd., a private company, is seeking financing. Why might it be advantageous for Sheng to use

IFRS rather than Accounting Standards for Private Enterprises (ASPE)?

A) It is less costly for Sheng to prepare IFRS financial statements.

B) It will give Sheng the appearance of an international company.

C) It will lower Sheng's audit fees.

D) It might enable Sheng to negotiate a lower cost of financing.

Answer: D



29) Which of the following statements about the use of GAAP for private companies is true?

A) Private companies must use IFRS.

B) Private companies must use Accounting Standards for Private Enterprises.

C) Private companies may use either full IFRS or Accounting Standards for Private Enterprises.

D) Private companies may use either modified IFRS or Accounting Standards for Private Enterprises.

Answer: C


Difficulty: Easy

30) Which of the following private companies is required to use IFRS?

A) Investment company

B) Import/export company

C) Manufacturing company

D) Accounting firm

Answer: A



31) John Smith is the controller of Excel Co., a private company owned by Rita Cooler. John receives a bonus equal to 10 percent of net income, before the bonus, as calculated in accordance with GAAP.

Required:

Explain how John Smith is both the preparer and a user of the financial statements of Excel Co. and whether or not he will likely try to defer income taxes.

Answer: As the controller, John will likely have primary responsibility for the preparation of the financial statements and will be responsible for the significant choices of many of the accounting policies.

He would be regarded as the preparer. However, John receives a bonus that is based on net income, and these financial statements will be used to determine John's bonus. So, John is also a highly interested user of the financial statements.

In order to receive the highest bonus, it is not unreasonable to expect that John would wish to maximize current period net income even if the company must pay higher income tax in the current period. With accounting policy choices that impact on taxable income, John may take action to maximize net income and would be unlikely to be motivated to defer income tax. In other areas, where accounting choices and choices for tax purposes were separate (such as capital cost allowance), John would be expected to attempt to defer income taxes.

Type: ES Page Ref: 5 8


32) Sam Stone is a financial analyst currently looking at a set of financial statements. After his review of the company's statements, he concludes that the statements report "high quality earnings".



Required:

Explain what is meant by "high quality earnings". In preparing financial statements that result in high quality earnings, what types of accounting policy choices will preparers normally adopt.

Answer: "High quality earnings" is a term used by financial analysts to describe earnings that correspond closely to cash flows from operations. Since investors use financial statements to evaluate current and future cash flows for an entity, high quality earnings are preferred to "low quality earnings".

Accrual accounting policies that record revenue and expenses as close to the cash basis as possible would be adopted to achieve high quality earnings. Specifically, policies that immediately recognize expenses, rather than capitalizing and depreciating over a number of future years would result in earnings that are closer to operating cash flows than policies that defer and amortize these costs.

In producing financial statements that reflect high quality earnings, note disclosures should also provide as much detail as possible about future commitments for cash. Debt repayments, lease arrangements and future purchase commitments are examples of this type of disclosure that is helpful in predicting future cash flows.

Type: ES Page Ref: 6


33) Sharon Peters is a controller is a New Start Co. She has just been informed by her CEO to "make sure that she chooses accounting policies that will have the effect of smoothing income".

Required:

What is meant by "income smoothing"? Why would a company be concerned about smoothing its income? How would income smoothing affect a user's perception of the company's results? Explain how income smoothing can be accomplished.

Answer: As part of the analysis, investors and creditors try to determine the level of business or operating risk associated with a company. The level of business risk impacts the cost of capital that will be assessed for this company. The more volatile a company's year over year results, the higher the business risk associated with it and the higher the cost of capital to be assessed. For example, if a creditor determines that a company's business risk is high, then he will demand a higher interest rate on the debt that is being advanced. As a result, preparers try to change the perception of this business risk by making the earnings less volatile on a trend analysis, resulting in a lower assessment of business risk.

Income smoothing can be accomplished by capitalizing expenses and spreading their recognition using depreciation or amortization over numerous future years. Similarly, revenue resulting from multiple service contracts can be spread out over many years, rather than be recognized all in one year. Net income smoothing is best achieved when expenses can be related to levels of revenue.





34) High Traders Inc. is a private Canadian company. The company adopted accounting standards for private enterprises early in 2009 since there were few changes required on changeover. However, a new

CFO has just been hired and now is suggesting that the company consider adopting IFRS in the near future.

Required:

Outline four possible reasons that a private company in Canada might choose to adopt IFRS. What would be the costs related to changing to IFRS?

Answer: A private company might decide to later adopt IFRS for the following reasons:

1.

The company is considering going public in the near future. As a public company in Canada, IFRS must be followed.

2.

The company may want to attract investors and creditors from investment funds, pension funds and other suppliers of private debt and equity. These users may require IFRS prepared statements, or assess the risk as higher for companies following accounting standards for private enterprises. A higher assessment of risk would result in higher interest rates on loans.

3.

The company may be considering expansion outside of Canada and want to raise either debt or equity in this other country. The potential investor or creditor may be familiar with IFRS and require this for the company's reports.

4.

The company may want to be acquired by a larger public company. In this case, IFRS prepared statements would be easier for a potential acquirer to analyze and forecast consolidated results if the acquisition is accomplished.

There will be higher costs to adopt IFRS. Whereas accounting standards for private enterprises has tried to simplify the accounting and disclosure for private enterprises, this is not the case for IFRS. So costs will increase to prepare statements under IFRS accounting policies and provide the additional disclosure that is required.





35) Management prepares the company's financial statements. Consequently, management's objectives will dominate the selection of accounting policies.

Required:

Give examples of users that might have the power to influence the accounting policy choices made by preparers.

Answer: The following are examples of users who might have the power to influence accounting policy choices used by management to prepare financial statements:

• Canada Revenue Agency has its own set of rules for determining taxable income. If CRA is the main user of the financial statements, management may decide to adopt accounting policies that are similar to the tax rules for revenue and expense recognition.

• Major shareholders sitting on a Board of Directors and/or an audit committee may influence the policies chosen to ensure that shareholder's objectives are also being considered.

• Security analysts and the financial press may have the ability to influence accounting policy choices by providing unfavourable coverage for a company if they disagree with the reporting of certain transactions and events by a company.

• Major lenders have the ability to influence accounting policy choices, particularly if the loan has certain covenants that must be maintained. Bankers could state how they wish to have certain transactions and events to be reported.


Difficulty: Easy



36) Many countries around the world have adopted International Financial Reporting Standards as their accounting standards. As a result, companies competing in the same industry, but operating in different countries should use the same accounting policies. This, in turn, makes interpretation and analysis of peers' statements listed on different exchanges far easier than in the past.

Required:

Is the above statement true? Explain

Answer: This statement is true but to a limited extent. Full comparability is actually an illusion.

Although IFRS has been adopted by many countries, analysis of the statements prepared by companies operating in different countries will still be difficult for the following reasons:

• IFRS has more choices of accounting policies, so different policy choices could be made by these companies.

• IFRS also requires more estimates to be used in preparing the statements, which can cause the results to be different.

• IFRS is not accepted to the same extent in every country. Some countries modify IFRS for its own national use resulting in possibly different accounting policies being used.

• Local circumstances may cause similar transactions to be accounted for in different ways.

• The ways of actually doing business in a country or the types of legal contracts that can be prepared may be different, resulting in similar transactions being recorded differently.

• The quality of auditing and professional expertise may be limited in some countries, resulting in statements not being presented fairly in accordance with IFRS.

• Enforcement bodies may be underfunded, again resulting in poor quality financial statements being prepared and issued, since there are no penalties that will be assessed.

• Economic factors such as inflation rates and foreign exchange rates could vary significantly from country to country. This could result in assets being revalued or lower amounts of monetary assets being held for some companies and not others.

All of these potential differences could impact the amounts reported for assets, liabilities, revenues and expenses by the companies, resulting in differences in ratio and trend analyses performed by the analysts.





37) XY Co. is a Canadian company listed on a US stock exchange. In the past, the company prepared a set of financial statements under pre changeover Canadian GAAP and another set under US GAAP. XY Co. converted to IFRS in 2010 for Canadian purposes, but is still considering preparing a second set of statements under US GAAP.

Required:

What are the current reporting requirements required by the SEC? Should the company be producing two sets of financial statements? Why is there pressure on FASB and the IASB to cooperate in preparing new accounting policy proposals? What do you think FASB will do in the future?

Answer: The SEC requires US companies to follow FASB pronouncements. However, foreign companies, like XY Co., can file using IFRS prepared statements instead. Ideally, this should eliminate the need for dual statements — one under FRS and one under US GAAP. However, if the primary users of

XY Co.'s statements are familiar with US GAAP, they may not understand IFRS prepared statements. As a result, these US investors may not bother to read and understand the company, so potential investors may be lost. Or alternatively, a higher risk may be assessed with these statements, causing the XY Co.'s cost of capital to be higher than necessary. Consequently, by issuing both types of statements, XY Co. may still be able attract these US investors.

FASB is the Financial Accounting Standards Board in the United States which sets the accounting policies for the country. Since the SEC has now allowed IFRS prepared statements, there will be pressure on FASB to harmonize with the IASB. In turn, for IFRS to be truly global, acceptance in the US market is vital since the US has one of the largest capital markets in the world. As a result, the two accounting bodies are working jointly on new accounting standard proposals to ensure that there is convergence on any new standards issued. The goal is to harmonize by 2015 or perhaps as late as 2017.

It is difficult to predict what FASB and the US will do. In the past, support for IFRS has fluctuated from acceptance to non acceptance, given the political climate in the United States. Because of its sheer size, US may decide to go its own route, which would in the end be counterproductive. Currently, US companies listed on foreign exchanges must report under IFRS, requiring two sets of statements being prepared. If

FASB adopted IFRS this extra cost would be eliminated for US based companies. On the other hand,

FASB would lose its power to drive new accounting standards in the United States, although they would still likely have significant representation on the IASB. As a result of this tension, it is currently difficult to predict what the final outcome will be. In the meantime, working to achieve as much harmonization as possible between FASB and IASB should go a long way to getting international comparability.





38) France, Germany, Japan and Canada are four countries that have adopted International Financial

Reporting Standards. As a result, auto companies from these nations will have similar statements, statement components, disclosures and measurement methods.

Required:

Discuss the "invisible differences" that may cause statements from the different countries to be less comparable and give examples.

Answer: "Invisible differences" refers to differences in the economic, political, legal and environmental systems within each country as well as the way of doing business.

Legal factors: One example of a legal factor is that in some countries taxable income and accounting net income must be the same. This may motivate management to choose accounting policies that will reduce earnings. Another difference in legal factors is that in countries where Islamic principles are followed, interest cannot be charged and therefore investors cannot lend money to companies and can only take an equity stake.

Ways of doing business: In Germany, employees and bankers are both represented on the Board of directors. For companies that have high debt balances, this is seen as favourable since the bankers must believe that the company will be profitable and able to repay these high levels of debt. In contrast, companies with low debt are seen to be unsuccessful, since the bank is unwilling to lend them any money.

In Japan, the corporate structure is very different from that in North America. In Japan, there is no parent company in a conglomerate structure and, instead, the holdings in other companies may be no more than

3%. The majority of the shares are held by a group, rather than a single corporation. Consequently, consolidated statements do not show all of the assets and liabilities of the entire group of companies.

Economic and political factors: Inflation rates and foreign exchange rates may vary from country to country. The amount of inflation in a country may influence the amount of monetary assets and liabilities that a company chooses to have.

State control and regulations within a country can also differ. For rate regulated companies, there may be motivation to capitalize as many costs as possible and use more debt to finance operations.





39) Private companies in Canada may follow either IFRS or accounting standards for private companies.

Required:

Why did Canada adopt accounting standards for private companies? What is different about private companies and public companies that require a different set of accounting standards? How did the AcSB design these private company accounting standards and why did it choose this option?

Answer: Canadian standard setters decided to adopt another set of accounting standards for private companies because private companies and very different from public companies. Private companies have a smaller number of users who are generally identifiable. Creditors are usually the bankers and shareholders are usually few in number. Both these users have access to management (or are management) and are in a position to demand more information if they have questions about the financial statements. This is not the case for public companies that are held by many investors. Since the users are easily identified and their needs are specific, there is no need for "general purpose" statements to be prepared.

When the AcSB designed the new accounting standards for private enterprise, the Board started with the pre changeover Canadian standards and modified them for private business. The AcSB chose this method for several reasons:

• Most private businesses were already using these standards and therefore were familiar with how to apply them in practice.

• Keeping similar standards would reduce the costs on changeover to private enterprise GAAP and maintain some consistencies with previous statements.

• The AcSB can adapt the standards to the Canadian economic and business environment.



40) Companies that find themselves with poor earnings in a certain year will often decide to take a "big bath".

Required:

Explain what a "big bath" is and the motivation behind it. Why does this type of earnings management

"tread very close to the line of ethical reporting"?

Answer: When a company has a loss year, there is a tendency to increase the loss by writing off assets and increasing expenses. The rationale for this action is that if the company is reporting a loss anyways, let's make it a large loss and "clean up the balance sheet". A "big bath" will motivate management to write down the assets as much as possible, particularly intangible assets where more estimates are required. By writing down the assets, this will reduce depreciation and amortization in future years, generating higher profits. Another motivation is to accrue higher future costs such as costs at the high end of the reasonable estimates for restructuring and reclamation. Again, this will increase costs in the current year, and reduce expenses in the future years. In fact, if the company has "over accrued" these costs, then reversals in future years will actually be recognized as a gain, increasing the company's profits.

This type of earnings management stretches the limits of accounting estimates and treads cost to the line of ethical reporting. There have been many cases in recent history, where there was deliberate misstatement of the accounting earnings to increase profits. The big question is that if these assets have really declined so significantly in value, perhaps they were actually over stated in the previous years when they should have been written down.




Advanced Financial Accounting, 6e

Advanced Financial Accounting, 6e (Beechy/Trivedi/MacAulay)

Chapter 1 Setting the Stage

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Advanced Financial Accounting, 6e

Advanced Financial Accounting, 6e (Beechy/Trivedi/MacAulay)

Chapter 1 Setting the Stage

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